Wednesday, November 26, 2008

How Federal Reserve Policy Has Reduced Wages

The economists who have been managing the money supply since the 1930s have generally followed a low interest rate policy in order to stimulate employment. When the Fed introduces extra money into circulation interest rates fall. This in turn stimulates economic activity because it is cheap to borrow. The additional economic activity results in hiring, and employment increases and unemployment decreases. This is the pattern that has motivated the Federal Reserve Bank's officially-induced inflation since the 1930s.

However, the long run effects of low interest rates may be opposite to the short run effects. There are strategic as well as stimulative effects of easy money.

The economic historian TS Ashton notices this in his little book The Industrial Revolution: 1760-1830.* Ashton notes that the course of innovation in 18th century Great Britain tended to respond to the availability of labor. Early innovation focused on harnessing the forces of nature. The success of this early innovation led to increasing population. But in the 1730s and '40s labor was still scarce and capital abundant, so:

"attention was centered on labour-saving mechanisms, such as those of Kay and Paul in the textile industries; and the search continued until in the 'sixties and 'seventies it culminated in the appliances of Hargreaves, Arkwright and Crompton. By this time the nature of the economic problem was changing: population was beginning to press on resources. The quickening of the pace of enclosure and the breaking in of the waste were the outcome of a growing demand for food; Watt's first engine and the Duke's canals were the answer to a problem set by a shortage of coal...Towards the end of the century and later, when rates of interest were moving up, some (though by no means all) of the inventors turned their minds to capital-saving ends. The newer types of engine of Bull and Trevithick and the newer ways of transmitting power, dispensed with much costly equipment...It would be dangerous, however, to press these generalizations far. There was often a lag of years between an invention and its application, and it was this last, rather than the discovery itself, that was influenced by such things as a growing shortage of materials or a change in the supply of labor or capital."

Taking Ashton at his word that the effects of policies are often approximate and long term, what would be the long as opposed to the short run effects of artificially stimulating the amount of available capital, i.e., the Federal Reserve Bank's artificially increasing the amount of money?

In the short run, in which the ratio of labor to capital is constant, demand for labor will naturally increase in proportion to the increased capital due to the Fed's monetary expansion. In the short run, the production function is constant, so the increased supply of capital increases labor demand.

In the long run, however, the production function is no longer constant. Production and innovation will focus on cost saving with respect to the relatively most expensive resources. Since capital has been made artificially cheap, the cost saving on which industry focuses becomes, because of Fed policy, finding new methods to save on labor costs. Capital investment focuses on saving labor through new machinery or alternative uses of capital such as plant relocation.

This, rather than enhanced transportation and reduced trade impediment may explain the relocation of plants overseas. General Motors, for example, has moved the majority of its plants to Mexico yet still complains about labor costs with respect to the slim percentage of remaining US employees. It costs money to move plants overseas. The learning required to competently manage a foreign plant is significant. Errors with respect to cultural differences, misunderstanding of legal systems, political risk, transportation costs (themselves reflecting capital costs) all amount to non-labor costs that are financed through reductions in capital costs.

Thus, over the long run, the Federal Reserve Bank effectively increases firms' strategic focus on capital investment by reducing the cost of capital. This has the perverse effect of reducing labor demand while increasing firms' profitability. This in turn leads to a two-tier economy in which technological workers who benefit from employment in excessively capital intensive firms earn super-normal wages while a large number are excluded because excessive capital investment has made their services redundant.

Traditional macro-economic models do not assume change in technology due to monetary policy. But firms have moved plants overseas because Fed policy has reduced the cost of doing so because it has increased the advantage of utilizing capital over labor (because it reduces capital costs). Strategically planning firms shift their production functions to invest more in labor-replacing capital investment. This reduces wages over the long term even as it stimulates labor demand over the short term. The labor-stimulating effects of new money are reduced over the long term, and like a drug addiction, the amount of money needed to achieve full employment increases at an increasing rate.

Thus, Keynesian policy in the long run produces results that differ from those in the short run. If this is so, we would expect to see higher wages from Keynesian policies from the 1940s to the 1960s, and lower wages from the same policies thereafter. This is what has occurred. However, rather than question their own assumptions, Keynesian economists seek elaborate, often illogical excuses in areas like blaming trade, income and capital gains tax policy and free market processes for declining real wages. This in turn leads them to advocate further capital investment and injections of money that stimulate labor demand in the short run but add to further replacement of labor by capital investment in the long run. Perhaps this is what futurists refer to as a coming "singularity", the ultimate replacement of human agency with machinery because of super-acceleration of technological advance.

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Mitchell Langbert

About Me

I have researched and written about employee benefit issues and in my previous life was a corporate benefits administrator. I am currently associate professor of business at Brooklyn College. I hold a Ph.D. from the Columbia University Graduate School of Business, an MBA from UCLA and an AB from Sarah Lawrence College. I am working on a project involving public policy. I blog on academic and political topics.